Berko: Understanding stock options

Four months ago, I was allowed to buy in as a new member of a large, successful investment club. I’m being mentored by an older member, and next month we’re assigned to recommend several growth stocks - “suitable for option writing” - with which we could make 15 to 18 percent returns. Explain options to me. Recommend several “suitable” stocks. Recommend several books to teach me about options.

P.J., Columbus, Ohio

Dear P.J.:

OK. As you command!

Assume you just paid $100,000 for a duplex producing $10,000 in rent and advertised to sell for $112,000. D. “Peewee” Trump Jr. reads your ad and says: “I may buy your duplex for $112,000 but need 12 months to think it over. If I pay you a $5,000 cash premium, will you write me a contract (an option) allowing me 12 months to think it over?” If you do, then three things can happen:

1. A year passes, and Peewee doesn’t buy the duplex. The contract expires, but you’ve received an income of $15,000 - $10,000 from rent plus Peewee’s $5,000 premium. That’s a 15 percent return, so you advertise it for sale again and sell another option.

2. At year’s end, Peewee buys the duplex for $112,000. Now you’ve received cash flow of $27,000 - $10,000 from rent, $5,000 from the option premium plus $12,000 from your stock profit. That’s a 27 percent return. Then you buy another duplex!

3. You repurchase the $5,000 option from Peewee within the 12 months. The purchase price may be higher than $5,000, lower than $5,000 or the same.

It works the same way with stocks. Suppose you believe that Ambarella Inc. (AMBA-$28), a niche semiconductor (systems on a chip) manufacturer with zero debt, will increase earnings by 50 percent this year and should trade in the low $40s within 12 months. You buy 100 shares for $2,800.

Now suppose someone’s willing to pay you a $500 premium (cash) if you sell him an option to buy 100 AMBA shares from you at $35 during the coming 12 months. Would you do it? Well, you must ask yourself:

1. How much can I make? And the answer is: If the option is exercised at $35, you’ll have a $700 gain on AMBA stock plus the $500 premium, which totals $1,200. That’s a 42.8 percent return in 12 months. However, if AMBA rises to $48 in those 12 months, you’re still obligated to sell it at $35.

2. How much can I lose? If AMBA goes kaput, which is highly unlikely, the maximum you can lose is $2,300 ($2,800 minus the $500 premium).

3. How long will it take to make this money? A maximum of 12 months but sooner if AMBA rises to $35 more quickly.

4. What happens to the dividend? AMBA doesn’t pay a dividend, but if it did, the dividends would be yours until the option is exercised.

5. What if I change my mind four months later and decide to cancel my obligation to sell AMBA? And the answer is: You can repurchase the option anytime at the market price, which can be higher than, lower than or the same as the $500 premium you received.

Other suitable stocks that provide 12-month option premiums in the 18 to 22 percent range, plus attractive capital gains, are: Zillow Inc. (Z-$81.89), which is making a resurgence in the housing market with record numbers of visitors and agents to its site. Revenues should be up 50 percent this year. Google Inc.’s (GOOG-$1,109.01) Motorola purchase now looks like a brilliant move. Along with its growing line of gadgetry, GOOG should continue to grow earnings by 30 percent. And Chart Industries Inc. (GTLS-$93.26) should grow earnings by 60 percent from its designing and manufacturing equipment for the production, storage and end use of hydrocarbons. These picks should impress the club members.

I can’t recommend books that teach beginners how to swim. Beginners need to jump in, get wet, feel their buoyancy, swallow some water, sink a little bit and keep stroking or learn to float.